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A transaction described in a private-letter ruling from the Internal Revenue Service resembles, but is not identical to, the recent divestiture by Citigroup of its Primerica stock. Similar to the case featured in the letter, the Citigroup transaction was carefully structured to achieve the benefits of Section 338(h)(10) of the tax code — benefits that often extend to the buyer and seller.

Indeed, Section 338 affords a newly formed company (Newco in the IRS letter) with a “cost” basis in the target company’s assets and, consequently, enhances depreciation and amortization deductions. The transaction begins with a four-company structure, in which a parent company owns all of the stock of AlphaCorp; Alpha owns 100% of the stock of SellerCorp; and Seller owns all of the stock of TargetCorp.

The parent, a publicly-traded corporation, is interested in exiting the line of whbusiness currently conducted by Target. To this end, the following steps will occur:• Seller will enter into a binding agreement with a purchaser, which will be an unrelated party. Seller forms Newco to participate in the transaction, and the agreement facilitates the sale to the purchaser of all the Newco preferred stock that Seller receives in exchange for property. Note that the purchaser will not transfer any money or other property to Newco in connection with the proposed transaction.• Seller will also enter into a firm commitment underwriting agreement in which Seller will be obligated to effect the sale of Newco common in an initial public offering (IPO);• Target will distribute certain assets to Seller.• Seller will transfer all of its equity in Target to Newco in exchange for 100% of the voting common stock and nonvoting preferred stock of Newco. Newco may also transfer a note to Seller.• Seller will sell the Newco preferred stock to the purchaser and a portion (which may be less than 20%) of the Newco common stock to the underwriters for cash for resale to the public.• A time limit exists with regard to Seller’s transfer of equity to Newco. As a result, Newco and the parent company (on behalf of Seller) will make elections under Section 338(h)(10) — in respect of Newco’s acquisition of Target’s stock — not later than the 15th day of the ninth month beginning after the month in which the transfer occurs.• Within a specified number of months from the time Seller sells the Newco preferred stock, Seller will undertake additional public offerings of Newco common stock or “other alternative transactions.” The additional offerings will reduce Seller’s ownership of Newco to less than 50% of the value of all of Newco’s stock. This final step is important in establishing that a stock “purchase” took place.

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To complete a Section 338(h)(10) election — which will provide Newco with a “cost” basis in Target’s assets — Newco’s acquisition of Target stock from Seller must constitute a qualified stock purchase.

The IRS ruled, in LTR 201015028, on January 4, 2010 (and released on April 16), that Newco’s acquisition of Target’s stock did, in fact, constitute such a qualified stock purchase. Further, the IRS determined that the parent company and Newco will be eligible to make the election under Section 338(h)(10) in respect of Newco’s acquisition of Target.

In the IRS letter, Newco acquired 100% of the stock of Target (from Seller) within a period not exceeding 12 months. As a result, if the stock was acquired by “purchase,” the acquisition of the stock will constitute a qualified stock purchase. (See Sec. 338(d)(3).)

Central to the question of whether the acquisition constituted a purchase is the notion of whether the stock acquired by Newco was from a related person. Indeed, stock acquired by a purchasing corporation from a related corporation is generally not acquired by purchase.

But as described in the letter, at the time Newco acquired the Target stock from Seller, Seller owned more than 50% of the value of Newco’s stock. Therefore, the stock would be viewed as acquired from a related person — and not acquired by purchase.

At the time the stock was acquired, Seller — because of its ownership of more than 50% of the value of Newco’s stock — is considered a person “the ownership of whose stock would be attributed, under Section 318(a) to the person (Newco) acquiring such stock.” (See Sec. 338(h)(3)(A)(iii).)1

However, in the case laid out in the IRS letter, the parties are permitted to measure Seller’s ownership of Newco after the additional public offerings or other alternative (divestiture) transactions are completed. This is so because the sale of stock to the purchaser and the IPO are merely steps in a single integrated transaction which encompasses the additional public offerings and/or other alternative transactions. Once those steps are taken, Seller and Newco will cease to be related parties, since the Seller’s ownership of Newco’s stock will dip below 50%. (See Sec. 318(a)(3)(C). )

The parent company stated that a sale to the purchaser and the public of less than 50% of Newco would not achieve the objectives of the parent in connection with the publicly announced divestiture of the businesses involved in an industry the parent wants to exit. In addition, the parent and the seller would not, based on advice received from their financial advisers, complete the transfers and the IPO without being “reasonably certain” that they would be able to effect a disposition of sufficient additional shares of Newco to reduce Seller’s ownership of Newco below 50%.

Therefore, the step-transaction doctrine properly applies to integrate the steps. It can be concluded, based on the parent’s representations, that the initial steps of the transaction would have been entirely fruitless without a completion of the entire series of transactions. In short, the parent’s business objectives could not have been accomplished if its interest in Newco exceeded 50%.

The regulations provide that, for purposes of determining whether an acquisition of stock constitutes a qualified stock purchase, a purchasing corporation is treated as related to another person if the relationship exists “in the case of a series of transactions effected pursuant to an integrated plan to dispose of the target’s stock, immediately after the last transaction in the series.” (See Reg. Sec. 1.338-3(b)(3).) In the IRS instance case, immediately after the last transaction in the series, Seller owned less than 50% of the value of Newco’s stock.

Since Seller owned less than 50% of the value of Newco’s stock at the point in time the regulations deem relevant, Newco’s acquisition of Target’s stock from the parent constituted a purchase of such stock.

1In addition, because of the presence of non-voting preferred stock, Newco’s acquisition of Target’s stock is not an “exchange to which Section 354 applies” — the acquisition, due to such nonvoting stock, cannot constitute a ‘B’ reorganization. Moreover, the acquisition is not an exchange to which Section 351 applies because, taking into account the prearranged sale of Newco’s preferred stock to purchaser, the “transferor” of property (Seller) to Newco with respect to its stock is not in control of Newco (within the meaning of Sec. 368(c)) immediately after the exchange.